Open excel file. Input salaries, taxes, overhead costs. Add margin as a percentage. You just calculated the prices for your software services. Right?
Not really. You only calculated your costs.
Even the margin of profit that you added to the fixed and variable costs is also just another type of costs.
It’s the cost of capital that needs to be returned to shareholders if you have investors in your company.
Or the cost of your personal time, effort, impact on your health and family life, if you are an entrepreneur still deeply involved in day to day operations.
Either way, when you add a profit margin to your costs as a way to calculate prices that will be charged to customers, you are taking a very limited view on pricing.
Why is cost-based pricing so widely used?
Because it’s easy to calculate.
Because most people think that this is “how we always did it”.
For many people it seems like the only “fair” way to calculate prices.
Because this is “how everyone in our industry calculates prices”.
And when everyone calculates prices in a similar way, over a long-enough period, as operating costs tend to equalise between different vendors, so will prices. Which leads to people thinking that is the “Right” Price.
Why is it harmful?
Since they don’t take into account the competition or the value of your services to the clients, most of the time they are not the optimum prices.
Either the prices are too high and you will not be competitive in the market. Which means you will have a hard time attracting customers.
Or the prices will be too low compared to what the customers would be willing to pay, which means that you will only capture a small fraction of the value that you created for your customers. This creates a strange effect, where the more successful you are (because you get a lot of customers), the worse off you will be, since you need to deliver for all those customers with a business model that is unsustainable because of the low margins that you operate with.
These low margins mean there is a very weak incentive for you as a vendor (or your employees) to improve and deliver higher and higher quality services. Which means you will be less and less competitive in the market.
WHAT THIS MEANS FOR YOU
It will help you a lot in the long run if you manage to give up on the habit of calculating your prices starting from your costs.
Read some books on value selling.
Watch some business movies.
Listen to some podcasts.
Anything that works for your learning style is good, as long as it helps you to get rid of the impulse of starting from costs.
Costs are one of the factors that impact pricing calculations. But it’s just one of many factors. And it’s nowhere nearly as important as most people usually make of it.